Secondary menu

Search form

Building bridges from mathematics to the City

By

The Plus Team

Submitted by Marianne on July 19, 2012

This article is part of a series celebrating the 20th birthday of the Isaac Newton Institute in Cambridge. The Institute is a place where leading mathematicians from around the world can come together for weeks or months at a time to indulge in what they like doing best: thinking about maths and exchanging ideas without the distractions and duties that come with their normal working lives. And as you'll see in our articles, what starts out as abstract mathematics scribbled on the back of a napkin can have a major impact in the real world.

Many people's impression of mathematics is that
it is an ancient edifice built on centuries of
research. However, modern quantitative finance,
an area of mathematics with such a great impact
on all our lives, is just a few decades old. The
Isaac Newton Institute quickly recognised its
importance and has already run two seminal
programmes, in 1995 and 2005, supporting
research in the field of mathematical finance.

"Quantitative finance is a fairly new area of
mathematics," says David Hobson, one of the
organisers of the Developments in Quantitative Finance
programme which ran in 2005. "It didn't exist
before the early 1980s and few academics classed
themselves primarily as researchers in
mathematical finance until about fifteen years
ago." Researchers were experts in other types of
mathematics – such as probability theory,
stochastic modelling, functional analysis and
numerical analysis, before moving into
mathematical finance.

Bringing together the City and the ivory
tower

"One of the ways the programme was successful
was in getting industry and academia together," says Hobson. "Research in mathematical finance
is undertaken in both universities and in banks.
But banks are very proprietorial about their
research and reluctant to share what they've done
as they think they will lose an advantage."
The programme gave credibility to industry
researchers who talked about their research,
allowing them to be seen as experts in that area,
which is, in itself, attractive to potential clients.

This interaction was of great benefit to the
academic researchers also. "It gave academics a
route into what banks are really interested in.
Otherwise there is a tendency to think about
interesting mathematical questions but not
important practical questions," says Hobson.

It was this aspect of bringing together so many
people from industry and academia that makes
this programme stand out. The programme had
55 long-stay and 153 short-stay participants. It
was, and still is, the largest programme held at the
Institute in terms of number of participants.
"Nearly everybody who was anybody in
mathematical finance passed through Cambridge
during those six months," says Hobson. "The
Newton Institute is unique. No other institute runs
programmes at the same scale as the Newton Institute. This
was the biggest long-term event in mathematical
finance that I'm aware of."

Pensions modelling

The programme not only brought together
academics and industry, it was also an important
opportunity for the fields within mathematical
finance to come together. Finance has two
mathematically separate industries: investment
banking and the insurance and pensions industry. Historically, actuaries in the
pensions industry have been
conservative in using sophisticated
mathematics. However, the current
debate regarding pensions may
result in more advanced
mathematical models being utilised.

"On average people are living
longer than they used to – that's nice
for us but it's causing problems in
funding pensions," says programme participant Andrew Cairns. At
the time of the programme he was
trying to model how the cost of
pensions might change in the future
and how much uncertainty there
was in those projections. The
programme, says Cairns, gave him
time to think more deeply about
serious problems. He was also able
to make presentations on his work
and receive feedback from his
assembled colleagues. "It certainly
helped to get feedback on that
research, and I would not have got
that if I hadn't been participating in
the programme."

One of his papers, the main part
of which was written during his stay
at the Institute, has been very
influential and this research is now
the basis for work in collaboration
with the pensions industry. "On the
back of that paper there has been a
lot of interest from the pensions
industry. Since then my
collaborators and I have been
working with JP Morgan: firstly to
educate the people buying pension
funds, and secondly to work with the
banks and other financial services to
manage that particular risk."

The simplest example of how this
risk is managed in practice is
something called a longevity swap.
Essentially the pension fund swaps
the payments to its pensioners (which
would carry on as long as they lived)
for a fixed set of payments with a third party, that is acting essentially
as an insurer. "There is a price to
pay for that but some pension funds
are willing to pay a premium to get
greater certainty over their future
costs." Cairns has been working with
JP Morgan on a set of mathematical
models, called LifeMetrics, which
are actively being used by the
industry. This is a new and growing
market. The value of longevity swap
deals already traded in the UK
market is estimated to be well over
£10billion by the end of 2010.

Looking to the future

"In a new area things advance
rapidly," says Hobson. Questions
that were important in the 1995
programme, such as modelling
interest rates, were already well
understood by the 2005 programme
and new questions were the focus of
research. Quantitative finance is an
exciting and fast moving research
area, and it is also very influential on
the finance industry and society as a
whole.

The 2005 programme, as well as the
global credit crisis that began in
2008, made one thing very clear:
more communication between
academia and the finance industry is
needed if sophisticated mathematical
techniques are going to be used
successfully in the markets.

"The real problem in the credit crisis
was a lack of understanding and
communication of assumptions and
limitations of the models," says
programme participant Andrew
Cairns. "The onus is now on the
banks and those that regulate them
to have people who can understand
the language of the mathematicians
at all levels, in order for them to
understand the risks."

Our digital lives rely on distributed computer systems, such as the internet, but understanding the order of events in such systems is not always straightforward. Leslie Lamport explains how special relativity helped him order events in computer science, enabling the development of distributed computing.